Russ MacKay

Tax Loss Selling Using Exchange Traded Funds

• Have you realized taxable gains in 1998, 1999, 2000, or 2001?
• Would you like to mitigate capital gains taxes?
• Do you hold stocks or mutual funds in a loss position today?

Tax loss selling has been an effective tax management tool used by savvy investors and portfolio managers for years. The concept is quite simple. You sell investment(s) that are in a loss position, and apply those realized losses against realized gains, thereby reducing the tax liability come April the following year. After waiting a 30-day period, you are then free to repurchase the security you sold (to avoid the superficial loss rule).

The problem we see in this strategy today is given the volatility of the market, there is tremendous risk NOT being invested for 30 days. Especially after what the markets have delivered, the probability of a rising market far exceeds the risk of it going lower.

So the question then becomes how can I be proactive and enact tax loss strategies, yet remain fully invested?

First, most investors (and advisors) are not completely up to speed on one of the most unique investment products available today. Exchange Traded Funds (ETF's) are individual stocks that trade on the exchange, and replicate the performance of their respective underlying index.

So let's look at a couple of examples on how to combine ETF's with a tax loss situation to provide an overall effective strategy.

Let's take the case of an investor who bought 400 shares of Cisco Systems on Feb. 15, 2000 in the midst of the technology frenzy, and paid US$64.00. The stock has suffered from the technology meltdown, and is now trading at US$19.20 (Nov. 9, 2001), yet the investor wants to be long technology. The solution would be to sell Cisco at $19.20, and immediately reinvest the money in the Nasdaq 100 Index (QQQ), of which Cisco is the largest weighted position, at a price of US$37.73.

What is the investor's end result?

Realize an US$17,920 loss to apply against realized gains in 1998, 1999, 2000, or 2001, or even file the loss for future use.

Remain fully invested in the technology market, thereby protecting from a near term rally in the sector.

Reduce risk by owning the sector, and not the additional risk of just one stock in the sector (in fact, over the time period above, the Nasdaq 100 outperformed Cisco by 16.90%!!!)

Let's look at another example, but this time an investor in the BPI American Equity Fund. In this case the investor purchased $50,000 of the fund at the first of January 2000 (after coming off a remarkable 1999 year of 52%). Now the investment is down over $16,000. The solution would be to sell the mutual fund, realize the loss, and invest the money in the S&P 500 Index ETF (SPY).

What is the investor's end result?

Realize a $16,000 loss to apply against realized gains in 1998, 1999, 2000, or 2001, or even file the loss for future use.

Remain fully invested in the US market, thereby protecting from a near term rally in the market. (80% of the top names in the fund coincide with the top names in the index).

Move into a more efficient investment. Reduced the annual MER from 2.59% to 0.08%, and increase the investor's probability of greater success. The fund returned 13.96% per annum over the last ten years, while the market returned 16.52% per annum, according to HySales 09/30/01.

What to do?

There are over 125 different ETF's available to investors today, so the opportunities to participate in these proactive tax strategies are definitely worth considering. Contact your investment professional to discuss these strategies.

Russ I. MacKay is a Business Development associate with McLean & Partners Wealth Management Ltd. in Calgary, Alberta, Canada.